Modern Portfolio Theory - Dead or Alive?

By Allan Roth

Updated on: January 16, 2011 / 9:28 PM
/ MoneyWatch

Modern Portfolio Theory (MPT) states that owning allocations of different asset classes that don't always move up or down together, is the best way of maximizing returns while minimizing risk. In the last couple of years, however, many have pronounced MPT officially dead. Let's see how it worked in the first eleven years of this century.

A diversified portfolio
Let's start at the beginning of the New Millennium with a $100,000, diversified, real-world portfolio, comprised of five low-cost funds. Those funds include US and international stocks, a little bit of real estate and precious metals, and a chunk of bonds. We will rebalance this portfolio at the end of each year.

First Market Plunge
Between the years 2000 and 2002, the stock market lost half its value. This diversified portfolio, however, barely breached the 10 percentage point loss. That's because REITs and precious metals moved in the opposite direction, as did bonds. By the end of 2007, the portfolio had grown to approximately $160,000. MPT worked well, but a Black Swan was about to hit.

Second Market Plunge - Enter the Black Swan
Beginning in 2008, the bottom fell out of the global economy. The real estate bubble took out the financial industry as well as several others. Paradigms broke and shifted, as they tend to do, and the "new normal" was introduced. How did MPT work from 2008 to 2010?

At first, REITs and precious metals moved in the same direction as the stock market. This shouldn't be surprising, as those asset classes have what are called low correlations, which means they often move in the same direction.

I asked advisor and author William Bernstein to comment on the differences of the two market plunges. Bernstein stated:

In 2000-2 the markets functioned in an orderly fashion, whereas in 2008-9 they did not. And when markets do not function properly, there are only two kinds of assets: riskless ones and risky ones. And the risky ones, every single one of them, get taken out and shot en masse. This is what happened in 2008-9, whereas in 2000-2, because the markets functioned normally and the preceding bubble was limited to only a few asset classes, this didn't happen.

MPT Shined - After it was Declared Dead
Today this portfolio is worth roughly $175,000, well above the pre-Black Swan high. And all that was required was to keep this portfolio allocation and ignore those announcing its death. Even fee-based financial advisors abandoned MPT and bailed out of stocks at the bottom. Investors who followed Bernstein's advice in his book, The Investor's Manifesto, did quite well.

My Take on MPT
Many professionals falsely assumed that alternative asset classes and bonds would always move in the opposite direction of stocks. The long-term correlations didn't support this conclusion, and betting that the next market plunge will look like the last one is always a mistake. Those professionals abandoned MPT right before its greatest success.

Sensational media claims, like The Great Depression Ahead or Dow 40,000, compel us to abandon logic and do things that look downright silly in hindsight. Those who stuck with MPT not only survived the Black Swan, but profited from it. That high volatility made rebalancing more valuable than ever.

Remember that MPT is mathematically driven, while investors are emotionally driven. Successful investing is math over emotions.

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.